ff Venture Capital and HBS Angels of New York are happy to be co-sponsors of Flashpoint’s upcoming New York Demo Day, Wednesday, January 18, 2012, 2:30 PM to 6:00 PM, held at Union Square Ventures.
Flashpoint is a startup accelerator program at Georgia Tech. Some of their portfolio companies look very promising. The current crop includes:
I hope to see you there! RSVP
Fundraising is not just limited to companies. Venture Capital firms have to do this as well. It is an interesting process and you get to meet fascinating people. Potential limited partners (or LP’s as we call them) come to the table with a set of beliefs that are, well, sometimes peculiar and rarely challenged – after all, the VC that is raising capital does not want to upset their potential investor. The net result is that certain “truths” often have to be addressed and given consideration, such as:
The underlying issue is that many LPs feel they know the fundamental requirements of a successful VC firm, have boiled it down to a few precepts, and anything that does not meet those precepts cannot work. This is the same logic as reportedly used in the argument that bumblebees cannot fly. Supposedly during dinner a biologist asked an aerodynamics expert about insect flight. The aerodynamicist did a few calculations and found that, according to the accepted theory of the day, bumblebees didn’t generate enough lift to fly. Once he sobered up, however, the aerodynamicist realized what the problem was: a faulty analogy between bees and conventional fixed-wing aircraft. Bees’ wings are small relative to their bodies. If an airplane were built the same way, it’d never get off the ground. But bees are not like airplanes, they are like helicopters.
We believe that the only way to measure success in venture capital is via returns, not firm structure: flight and not ones assumptions about flight. Now success can also be due to simple luck, but a long consistent track record would indicate process has something to do with it. In fact, a continually refined process. For us returns are a function of process which breaks down into finding great companies, selecting those you want to work with, and then determining the amount of capital to deploy each time there is an opportunity to invest, or simply:
Success = returns = deal-flow + selection + deal negotiation + portfolio management
Far too much discussion is based on deal flow, and in particular the notion, or belief, that hot deals lead to successful companies. As a firm, we are wary of hot deals and far prefer ones that are ‘cold’. Why? Well, as we invest at an early stage, we want to invest ahead of an opportunity, preferably 3-5 years ahead. As such if a deal is hot, then the idea is likely of the now and not the future, and the company will not have the time to grow to the right size and heft to dominate that opportunity. Successful companies, like successful people, often have tough childhoods and adolescent periods – there is no silver spoon. Deal selection is simply tougher that latching onto the next hot idea, the theme-du-jour, the company with the cool kids or the cool co-investors. We love cold deals with no ‘social proof”, just amazing CEO’s and management teams.
Larger funds are at a triple disadvantage vs. smaller funds:
(A) No professional active money manager should be too diversified, and so focusing on investments below 0.5% of their capital base is asinine. No fund manager can seriously do so as fund management is a matter of balancing time on a portfolio position vs. the potential return. The capital that is most scare is intellectual capital.
(B) The people working at the fund focused on seed investments tend to be the most junior. They will feel they have been given the short-stick opportunity, as whatever they do they feel that they cannot move returns for the whole fund. The fund will also feel conflicted out of putting larger amounts of capital to work in competitors when the early stage company almost inevitably pivots in a space that is just emerging.
(C) The tool-set for early stage investing is simply different. The toolset that makes for a typical partner at a $500mm VC fund is different than the toolset needed for early-stage deals. The early stage toolset is way more qualitative than quantitative.
The bar of having ”a broad deep team of senior investment professionals” is interesting – after all who can argue that more talent is better. After having worked at Goldman Sachs and some other very large companies, I fully understand the value of a large team, but the downside of a large team is that it leads to groupthink and a consequent conservatism – remember the quote about a camel having been designed by a committee. In addition, a large team creates a higher cost structure that requires a larger fund, which is counter to our approach.
So many people manage money so that they can manage more money. The management fee that is insignificant for a small fund becomes a raison d’être for a large fund. Their objective is to manage the maximum possible so that they can have significant asset based fees and be less reliant on performance fees. They become asset gatherers. One of the most successful asset gathering strategies is to specialize. After all, a specialist will know much more about something than a generalist. That leads to higher returns, right?
As a firm we respectfully disagree, especially with regard to the world of early-stage investing. This is despite some academic research on later-stage investing that has indicated some advantages to specialization for later-stage funds; see “The Performance of Private Equity Funds: Does Diversification Matter?” Specialists focus on areas they think that investors want to invest in today, and so are always proposing the theme-du-jour. In early stage investing, this is a bit like fighting the last battle. Early stage investing is a long-haul game, and not one that should be tied down to a tantalizing theme during the capital raising period. Technology moves too fast to tie a successful fund down like that. Specialist investors have to turn down investments that they think are going to be successful if outside of their theme. Specialist investors that are hands-on cannot invest in the best companies in the space; as they might compete. If they are not hands-on then they cannot help their companies succeed and have to watch from the sidelines. Specialist investors have one hand tied behind their backs.
When my partner, David Teten, wrote his research study on best practices in deal origination, one of the people he spoke with was Bill Morrow, formerly COO, Mid Europa Partners, a European private equity fund, which is comprised of a team of 30 people from 19 different countries. Bill observed, “We have deliberately not chosen a country-specific origination model, because we’re afraid of adverse selection. If you pay someone to eat what he kills in Romania, he may bring something not palatable back from Romania because that is all that was available.”
Bill went on to say: “Similarly, we’re debating the extent to which we should be sector-focused. We’re wondering to what extent a well-defined sector focus is good or bad. It comes with some logistical issues. If your focus is retail, and nothing is going on in retail, then you’re either a wasted talent or again face adverse selection. We want our people to be fungible. We don’t hire the Czech investment professional just to originate Czech deals, although we recognize he or she will be more likely to source deals in that geography.”
Similarly, in Robert Finkel’s excellent book, The Masters of Private Equity and Venture Capital, there’s an interview with John Canning, chairman of Chicago private equity firm Madison Dearborn Partners LLC. He observed that during the telecom bubble, his team thought of creating a dedicated telecom fund, because they had made so much money from telecom investments. Madison Dearborn did not, and were very glad about that decision with the advantage of hindsight.
We are unapologetic generalists and invest for returns. We think that limited partners actually want returns and we work to deliver them. Specialization is a sub-optimal strategy for early stage venture capital.
So, how do you measure success in the space? What are the best proxies for future returns? We maintain it is having a philosophy of investing for returns in a fund with aligned interests and a proven track record that is way above the median for the space. Returns are all about looking at a ton of deals and finding the few management teams you want to work with, then working with them and giving them more capital as they succeed. It is a long game, it is an unconventional game, and it is tremendous fun.
Look out for the bumble bees.
 Bumblebee takeoff by Manechka |
We are entering a new era. A time when great wealth is being created, and old fortunes destroyed (but not let us dwell there). A time of convergence and disruption that has not been seen in anyone’s lifetime.
In the late 90′s it was all about expectation and a belief that disruption of existing businesses was imminent; well, a decade or so later it now is. This is why the current (and upcoming) crop of Internet leaders are, well, generating revenues and profits. This is not about eyeballs anymore.
There are three main drivers, and their convergence is unlocking new money making opportunities at an increasing pace:
(1) existing established companies in many fields are being materially impacted by new secular disrupting technology;
(2) the establishments of new cheap, accessible distribution platforms; and
(3) the willingness of large (and small) enterprises to experiment with new way of doing things and work with unestablished companies.
Examples of new secular disrupting technology: SaaS services, cheap cloud storage and processing, powerful mobile platforms (phone and tablet), new touch and motion interfaces, ubiquitous API’s, social platforms (i.e. people giving up privacy for fun or ease of access/use), and location based services.
Examples of new cheap, accessible distribution platforms include iOS iTunes, Android, Facebook, Google Apps, and YouTube.
And, finally successful execution by high profile companies, low cost of experimentation, an ample supply of smart unemployed people and a societal recognition that tech is cool, as evidenced by The Social Network.
I cannot think of a time when so much disruption was happening from so many different technologies impacting so many different parts of the economy. Thus I am not in the “It’s a bubble” camp, but in the the “It’s a bull market” camp. Is this driven in part by cheap money, by a lack of investment returns elsewhere and by a sense of glamor, but those are the ingredients of a good bull market. If I had to guess, I would say it is ’96 or ’97 again and we have a few more years before a blow-off top that will be called The Second Internet Bubble, or something like that. Right now it is rational to invest in start-ups, though at some point it might make sense to step back. As a professional investor I have to understand when to participate and when to pull back and now is the time to invest and help companies, not hold back. Real wealth is being generated, real jobs created and real change is happening.
Innovation is very much alive in America and gives one great hope for the future of the country.
[Source www.500px.com]
I co-joined these two blog entries as no discussion of what is happening does not involve someone raising the concern that we are in a bubble right now. I think, and have argued above, that that is not the case…but, it most likely will be. I can see such a thing happening three or four years from now, when everyone is sucked into the private markets and quite comfortable with their highly illiquid (but seemingly liquid) investments in companies they do not understand and yet they seem to be making money.
Bubble require liquidity and liquidity in private investments is restricted by many constraints, though the following are worth highlighting:
(1) regulation that only allows accredited investors to invest;
(2) regulation that restricts number of shareholders to 500, or burdensome reporting requirements kick in;
(3) lack of information related to how the company is performing; and
(4) institutional investing by mutual funds, brokers, etc. only make size in units of $10mm and so cannot happen until the market caps are sufficiently large (probably $500mm minimum).
I suspect that over the next few years (1) and (2) will be loosened, and (3) will stay the same, but investors will not care. (4) is the real indicator of where the bubble will be. It will be when mutual funds start to buy into private companies pre-IPO in a hot space, it will be when the public can participate pre-IPO through funds set up by the Bulge Bracket firms, it will be when secondary share trading grows to the point that “everyone” starts doing. These will create a false sense of liquidity at the $500mm market cap level and above, and that will give everyone some comfort until it goes away. Professional angels and VC’s will probably be more than willing to sell into this frenzy and take advantage of the liquidity provided. Fortunes will be made and fortunes lost, but the bubble will have to be later stage. Can this bleed down to the early stage? Perhaps, but far less so. The numbers are just too small.
Time will tell, but my thoughts are now date-stamped by this post.
[Note to self, check back in 3 years.]
I really did not want to post about the Yuri Milner/Y Combinator/SV Angel announcement, but felt that there was something lacking in the debate.
Like Roger Ehrenberg I think this is a “ho-hum” announcement, but time will tell. There are various surveys and analyses out there, and all the numbers are slightly different, but the order of magnitude is that there well over 100,000 angels making over 50,000 investments for a total amount of $15bn+/-, each year. One angel’s investment in 43 startups for $6mm does not move the needle. It makes GREAT news, however and there are already four TechCrunch articles about it. It seems the valley is, well, narcissistic.
There is also the law of unintended consequences: does this mean that talented folks that are hands on and helpful to startups will avoid YC in the future if they feel that they cannot invest at fair prices. Time will tell. A rigged game does not attract talent, it attracts fools. You also have to wonder if Yuri is buying options, then the companies must be selling them. My time on Wall Street told me selling options can be a sucker’s game. And then there is the questions as to whether there be a signaling issue? Would you invest in a company that Yuri has decided to pass on in a later round?
Overall, I can understand the attractiveness of the money, but there is no such thing as a free lunch.
Sanjay Anandaram posted a great article in Plugged.in, and I suggest that you read the full article, though to get his full perspective. The money quote for me is:
Today I know that a feature doesn’t make a product. A product doesn’t make a business; And most importantly, a business doesn’t make a company. A company is a means of organizing a business.
People who know me know that one of the first filters I apply when looking at a company is whether the offering is a feature, product or business. It is the talent of management and the nature of the revenue model that converts it from something that can easily copied into something that can start to be defensible. Being defensible is key. Why? Well, because let’s say that you have discovered a new market that others have not yet, and a way to extract profits from that market. What stops others from following and dominating the market you discovered? Financial services are full of new markets being discovered and where the margins are fat enough Goldman Sachs would move it as a fast follower, and often dominate.
So, how do you stop a fast follower? Often you cannot. You are left with two scenarios. Either you have a structural advantage from being first. eBay is a great example whereby the network dominance from being first sucked out the opportunity of others to catch up. It was not that it was eBay that allowed them to dominate – personally I feel the site was designed by a sixth grader – but by being first with a sufficiently functional product. In Japan they were second and lost to Yahoo Japan. Alternatively, you simply have the best execution, which can involve a decent amount of luck at the right time. Execution is a bit like pornography – tough to define but easy to identify.
So, if you are an entrepreneur think carefully if you have a defensible business model (when you execute) or not. If not then the profits you could make will not be yours. If you have a product then work out how to get it to be a business and if you have a feature, well, go back to the drawing board.
As a child I read books about Transactional Analysis and OneUpmanship, probably at the prompting of my mother. I found these interesting in the way they described bow people play games in life and expect a reaction for every action. Have you never been in a crowd and someone waived to you? You probably waved back, even if you had no clue who there were. Even so, I have generally thought that only part of society really runs with this quid-pro-quo mentality, and only for part of the time. It is an interesting analysis but not core, mainstream or how we all live our lives.
It was not until I saw Inception with my wife that I thought about these ideas again. Inception for me was an indication of how far game mechanics have now infused society, and game mechanics are simply the modern-day representation of these ideas I was exposed to in my formative years. What was it about Inception? Well, my wife is not a gamer, and yet the movie was not “strange” to her. It was just another romantic, thriller. The plot, however, revolves around not just a gaming structure, but with rules espoused throughout the film. This was not jarring as more and more of our experiences, online and offline are becoming rule-based with prizes, points, quid-por-quo built in. We used to say that gaming would change computer interfaces and impact reflexes, and though that might still happen is it is the logic of gaming that is changing us first. Some of the fundamentals of games are working their way into society at large.
Given that I am a VC does this perspective change how I look at companies? In some way it does. Game mechanics can affect adoption and are built into the business models of hashable, Identified.com, Klout, Livefyre, OfferIQ, ORCAone, and Phone.com. I suspect that more will be built in in these and other companies over time. To link buzz words from not to a decade a god: Game mechanics can increase the stickiness and viral adoption of your site as we are and have been trained, or re-programmed, to think this way. Like Pavlov’s dog playing Wii.
A few days ago Dave McClure posed this:
This is an interesting discussion as it ties in closely with an increasing amount of capital being deployed in the early stage VC space, be it by funds like ff Asset Management and even some larger traditional VC funds. Entrepreneurs that have oversubscribed rounds are then forced to allocate, and when the allocate they then should carefully examine what is the motivation for the investor to invest in their company, as well as what is the quality of the money? Many startups will not face this dilemma, but as the capital drought of early 2009 has been replaced by the glut of late 2010 more and more startups are having this “problem”. This is despite the withdrawal of funds by angels themselves. In 2007 $26bn or so was invested by angels. In 2009 this fell to, perhaps $12bn. This has recovered in 2010, but not to the 2007 levels. VC’s, on the other hand, because of the long-term nature of their funds still have plenty of capital to deploy.
All funds are managed for return (or should be!), and return is a function of the size of investment and time devoted to the investment for any actively managed VC portfolio. I personally think that if the fund is investing well less than 1% of the total fund’s size in an investment then there is a risk of misalignment of interests between the investor and the entrepreneur. Remember, the investor is buying an option to participate if the company is successful, and walk away if not. That is generally fine, but it can pose a risk for the startup if it is a large traditional well known VC where people will care if they do not re-up. If the investor’s fund will end up with well north of 50 investments in the fund at maturity, then there is the question of whether the startup will get sufficient attention from the fund’s principal(s) for the money to be treated as “smart” money and not “dumb” money. Finally, if the fund is spread too thin, then the fund will not have the capital for follow on investments, and new relationships will need to be developed at the next round – not a real problem, but something to understand.
Bottom lime, if you have an oversubscribed round then understand the motivation of each investor and their fund: If there is alignment, great; if not, then think carefully if you expect your investor to invest not only money but also time.
If you are not oversubscribed then consider this article (which like most “news” overstates the situation):
One person we know who has a startup trying to raise money was floored at how easy it was to get a small slug of cash. It was basically a short phone call with a potential investor who said, “I’ve heard good things about you from people I trust. When you’re ready for me to invest, just call me back.”